Friday, May 1, 2015

How to Take a Loss

There are quite a few books written on how to make money in the market. Some
of them are even written by people who have made money as traders! What you don’t
see often, however, are books or articles written on how to lose money. “Cut your losers
and let your winners run” is commonsensical advice, but how do you determine when a
position is a loser? Interestingly, most traders I have seen don’t formulate an answer to
this question when they put on a position. They focus on the entry, but then don’t have a
clear sense of exit—especially if that exit is going to put them into the red.
One of the real culprits, I have to believe, is in the difficulty traders have in
separating the reality of a losing trade from the psychological sense of feeling like a
loser. At some level, many traders equate losing with being a loser. This frustrates them,
depresses them, makes them anxious—in short, it interferes with their future decisionmaking,
because their P & L is a blank check written against their self-esteem. Once a
trader is self-focused and not market focused, distortions in decision-making are
A particularly valuable section of the classic book Reminiscences of a Stock
Operator describes Livermore’s approach to buying stock. He would sell a quantity and
see how the stock responded. Then he would do that again and again, testing the
underlying demand for the issue. When his sales could not push the market down, then
he would move aggressively to the buy side and make his money.
What I loved about this methodology is that Livermore’s losses were part of a
grander plan. He wasn’t just losing money; he was paying for information. If my
maximum position size is ten contracts in the ES and I buy the highs of a range with a
one-lot, expecting a breakout, I am testing the waters. While I am not potentially moving
the market in the way that Livermore might have, I still have begun a test of my breakout
hypothesis. I then watch carefully. How are the other averages behaving at the top ends
of their range? How is the market absorbing the activity of sellers? Like any good
scientist, I am gathering data to determine whether or not my hypothesis is supported.
Suppose the breakout does not materialize and the initial move above the range
falls back into the range on some increased selling pressure. I take the loss on my onelot,
but then what happens from there?
The unsuccessful trader will respond with frustration: “Why do I always get
caught buying the highs? I can’t believe “they” ran the market against me! This market
is impossible to trade.” Because of that frustration—and the associated self-focus—the
unsuccessful trader does not take any information away from that trade.
In the Livermore mode, however, the successful trader will see the losing one-lot
as part of a greater plan. Had the market broken nicely to the upside, he would have
scaled into the long trade and likely made money. If the one-lot was a loser, he paid for
the information that this is, at the very least, a range-bound market, and he might try to
find a spot to reverse and go short in order to capitalize on a return to the bottom end of
that range.
Look at it this way: If you put on a high probability trade and the trade fails to
make you money, you have just paid for an important piece of information: The market
is not behaving as it normally, historically does. If a robust piece of economic news that
normally sends the dollar screaming higher fails to budge the currency and thwarts your
purchase, you have just acquired a useful bit of information: There is an underlying lack
of demand for dollars. That information might hold far more profit potential than the
money lost in the initial trade.
I recently received a copy of an article from Futures Magazine on the retired
trader Everett Klipp, who was dubbed the “Babe Ruth of the CBOT”. Klipp
distinguished himself not only by his fifty-year track record of trading success on the
floor, but also by his mentorship of over 100 traders. Speaking of his system of shortterm
trading, Klipp observed, “You have to love to lose money and hate to make money
to be successful…It’s against human nature what I teach and practice. You have to
overcome your humanness.”
Klipp’s system was quick to take profits (hence the idea of hating to make
money), but even quicker to take losses (loving to lose money). Instead of viewing losses
as a threat, Klipp treated them as an essential part of trading. Taking a small loss
reinforces a trader’s sense of discipline and control, he believed. Losses are not failures.
So here’s a question I propose to all those who enter a high-probability trade:
“What will tell me that my trade is wrong, and how could I use that information to
subsequently profit?” If you’re trading well, there are no losing trades: only trades that
make money and trades that give you the information to make money later.

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